How to govern investments during regime shifts

We live in a world of regime shifts: a pandemic, trillions of dollars of debt and the climate crisis, as well as social, technological and political transformations. The future for our world and for the investments we make will look very different than what came before.

Classic asset management strategies are becoming outdated, and organizations and individuals stuck in these legacy processes need to reconsider. But how can we develop best-in-class governance of investments for this deeply uncertain world?

The sound governance of investments is based on four core principles:

Figure 1: The four core principles in regime-shift investment governance

Principle 1: Objectives and constraints

The definition of clear objectives is key. Some investors have high-level generic objectives but no specifically defined objectives. Not everybody wants increased expected returns. Some want to handle uncertainty, some want resilience and others prefer a target on volatility.

Then come constraints, which may well be economic, political, or even social and cultural. They will affect how we invest optimally, especially in dynamic times. The simplest of all constraints are economic liabilities. From pension liabilities to corporate debt, these liabilities need to be considered for a successful optimization.

While it seems natural to consider objectives and constraints separately, they often need to be combined. For example, funds may have multiple objectives. A composite objective needs to be created, and may need to factor in several dimensions, such as financial performance, sustainability or differing time horizons.

Additionally, stakeholder views must be considered according to different stakeholder agendas. Once objectives are clearly defined, professionals can align the investment strategy accordingly. Often multiplicity must be dealt with at the organizational level: boards, trustees and consultants can present contradictory perspectives that are the result of a weak compromise. Classic board or committee governance then becomes essential to drive the right focus.

Our experience shows that we are less concerned by complexity than by the lack of clarity and focus. Portfolios exposed to the former widely outperform those exposed to the latter.

Principle 2: Values and culture

We are confronting significant challenges in the world: high levels of debt, climate risks and the menace of stranded assets.

Good governance standards enhance investments. Investments in turn are a driving force of social development and well-being. A culture of good governance within an organization is thus an integral driver of shared success.

Such a culture is reinforced by four key factors: 1) quality individuals, that are knowledgeable, focused and dedicated, with clear roles; 2) well-designed, rich information and high transparency; 3) sophisticated processes; and 4) accountability, openness and constructive dissent.

Above all, stewardship – the knowledge that we are here to pass on to the next generation something better than what we inherited, and the ability to include the long term with the social impact of our choices – is vital.

No investment governance is possible without underlying values and culture. Investments, while managed long term, are essentially intergenerational forces that will shape the future for our children.

Principle 3: Forward assumptions and views

In a world of regime shifts, forward views that consider the full spectrum of possibilities require open minds from diverse backgrounds and dimensions that can leverage deep expertise. Forward views open the range of outcomes necessary for good risk and opportunity thinking.

Scenarios based on the mathematical modelling of complex systems allow a more consistent approach than gut-feel market views. By scenarios, we do not mean stress tests or projections of catastrophic perspectives, but true changes in fundamentals that impact investment performance and change the fundamental assumptions behind diversification in a realistic way. They are a prime decision-making tool.

Alongside classic fundamentals such as policy and data, social, environmental and cultural evolution would also ideally be part of these scenarios. These forward views open the funnel of possibilities, and they also help frame portfolios across time horizons.

Figure 2: Forces underlying regime shifts
Source: BERG Capital Management

Such scenario-based forward views enable a rational approach to dynamic asset allocation, matching a risk budget that bridges the risk tolerance of the fund trustees with their risk appetite among different world contexts. When done well, it then becomes a fundamental driver of performance.

Principle 4: Top-down across asset classes

In the past, trustees often relied on basic metrics of performance of each asset class such as alpha and beta. Unfortunately, this traditional construction has grown obsolete.

Today’s risks hit across classes – and often performance drivers – too. This means understanding and driving a portfolio top-down across asset classes.

Good investment governance here consists of identifying the top-down risks/opportunities, and minimizing the downside risk of being wrong while maximizing the upside risk of being right. Identifying the key dimensions to consider requires good governance principles: diversity of perspectives for creativity and innovation, constructive dissent for open and productive discussions, and good chairmanship toward rich and conclusive perspectives.

A top-down investment approach can be implemented in two ways.

First, the approach can feature a traditional repositioning of the portfolio from a bottom-up perspective. This can include adapting benchmarks, or reflecting on the concentration of investments, changing the investment management mandate in terms of sector, selection of geographies, shifting allocations from one asset class to another or using liquidity for new objectives or constraints.

Second, it can dynamically use the risk tolerance or policy range within a portfolio. This latter methodology consists of dynamic smart rebalancing. It works like a super tanker that uses a slight shift of power and direction, and reorients itself via its own natural inertia.

In times of regime shifts, the governance of investments is central to success. Legacy structures and processes are challenged, but our experience shows that four core principles – objectives and constraints, values and culture, forward views and top-down across asset classes – are the key to a successful practice.

For further insight and key questions to help you navigate the four core principles of good investment governance during regime shifts, please download the full version of this article here.